Friday, August 14, 2009

Citigroup (NYSE:C): Upgraded to Buy from Underperform at Merrill Lynch/BAM

Merrill Lynch/BAM is making a major call upgrading Citigroup (NYSE:C) to Buy from Underperform and raising their target price to $5.75 (prev. $2.50)

The analyst Guy Moszkowski is upgrading C to Buy from Underperform because: in firm's view, credit quality is stabilizing; technical overhang of new-share issuance is past; and, given Citi’s new disclosure of core Citicorp vs non-core CitiHoldings, they see limited bookvalue downside potential. PO is $5.75, about Book Value.

Consumer credit quality stabilizing; psychology shifting2Q bank results showed consumer credit delinquency stabilizing, which should drive better credit loss trends in quarters ahead. This is of course key for Citi and its large portfolio of mortgage and other consumer debt. With crisis largely past for Citi, we believe psychology on the company is changing.

Technical risks have passedOn July 30, Citi converted $58bn of Preferred to Common, quadrupling share count and doubling float (some shares, such as US Government’s, will not trade immediately). Merrill Lynch notes they were concerned about this technical overhang, which did briefly bring the shares near their downside target, but it has now passed.

“Worst-case” scenario suggests limited downsideCurrent BVPS est. at $5.91, diluted for recent preferred-to-common exchange; and Tangible at $4.28. Merrill's “burn-down” severe-case analysis puts Book no lower than $3.88 in ‘11. More realistic look suggests ‘11E BV could approach $7. Also, Tier-1 Common ratio remains well above 4% in their “worst-case” scenario, suggesting to us recent preferred-to-common exchange has provided more than sufficient capital cushion which was the objective of the gov’t “stress test” exercise and the exchange.

PO of $5.75 as Book Value stabilizesROE in ‘11, as earnings begin to normalize, forecast at 10-11%, so they expect C will, in the next 12 months, trade at around Book. Thus our PO moves from $2.50 to $5.75. Prior PO was based on worst-case outcome, and on Tangible, not Stated, Book. But history suggests C will likely begin again to trade based on actual, not tangible, BV with probability of “worst-case” outcome receding at this point.

Notablecalls: This surely is a major change in thesis from one of the largest investment firms. Merrill is out saying there is at least 40% upside in C.